Tuesday, October 14, 2008

Dimon in the Rough

PepsiCo Inc. lost 12 percent, the most since 1982, after lowering its profit forecast as customers cut back on snacks and soft drinks. Microsoft Corp. and Intel Corp. slid more than 5 percent as analysts said demand for computers is slowing. Morgan Stanley, Citigroup Inc. and Merrill Lynch & Co. added more than 18 percent, sending banking shares to a third straight advance.

``Notwithstanding the government and Treasury's actions focusing on financials, the general economic environment has deteriorated quite a bit in the last five or six weeks,'' said Jonathan Armitage, head of U.S. large-cap equities at the American unit of Schroders, the U.K. manager of $259 billion. ``You're just seeing different parts of the equity market reacting to that.''

The Standard & Poor's 500 Index slipped 5.34 points, or 0.5 percent, to 998.01 after gaining 12 percent yesterday. The Dow Jones Industrial Average decreased 76.62, or 0.8 percent, to 9,310.99 after a 936-point rally yesterday. The measure swung more than 700 points from its low to its high today. The Nasdaq Composite Index declined 65.24, or 3.5 percent, to 1,779.01.

The big winners today were regional banks like Keycorp (KEY), up a whopping 54% today.

Calling the need to inject money into banks regrettable, Paulson said it was nevertheless necessary.

"The alternative of leaving businesses and consumers without access to financing is totally unacceptable," Paulson said. "When financing isn't available, consumers and businesses shrink their spending, which leads to businesses cutting jobs and even closing up shop."

Bernanke, echoing Paulson's comments, said that "Americans can be confident that every resource is being brought to bear," including political leadership. He also said he strongly believed that the measures, together with resilience of U.S. economy, would "help restore confidence."

...

Paulson outlined the plan to eight of the country's leading bankers at a meeting late Monday. He essentially told them that they would have to accept government investment for the good of the American financial system, according to officials.

On Monday, big banks agreed to take investments totaling about $125 billion. Citigroup and JPMorgan Chase will receive $25 billion each. Bank of America, which is acquiring Merrill Lynch, and Wells Fargo, which is acquiring Wachovia Corp., will each receive $25 billion. Goldman Sachs and Morgan Stanley will receive $10 billion each. And Bank of New York Mellon and State Street will get $2 billion to $3 billion.

Another $125 billion is allocated for thousands of small and midsize banks. They will be eligible for government investments reflecting a similar proportion of their assets.

On Tuesday, Paulson said that in return for the investments, the government would receive preferred shares and warrants for common stock. In addition, the government will expect a reasonable return, he said.

What is more, he said, "institutions that sell shares to the government will accept restrictions on executive compensation, including a claw-back provision and a ban on golden parachutes during the period that Treasury holds equity issued through this program."

But injecting capital into banks was part of the solution. The other was guaranteeing bank debt, especially senior bank debt and raising federal deposit insurance to cover small businesses:

...officials said they hoped that the guarantee on new senior debt would have an even broader effect than an interbank lending guarantee because it should also stimulate lending to businesses.

Another part of the government's remedy is to extend the federal deposit insurance to cover all small-business deposits. Federal regulators recently have been noticing that small-business customers, which tend to carry balances above the federal insurance limits, have been withdrawing their money from weaker banks and moving it to bigger, more stable banks.

Congress already raised the federal deposit insurance limit to $250,000 this month, extending coverage to roughly 68 percent of small-business deposits, according to estimates by Oliver Wyman, a financial services consulting firm. The new rules will cover the remaining 32 percent.

"Imposing unlimited deposit insurance doesn't fix the underlying problem, but it does reduce the threat of overnight failures," said Jaret Seiberg, a financial services policy analyst at the Stanford Group in Washington. "If you reduce the threat of overnight failures, you start to encourage lending to each other overnight, which starts to restore the normal functioning of the credit markets."

Note, however, that recapitalizing banks carries its own set of risks:

Recapitalizing banks is not without its risks, experts warned, pointing to the example of Britain, which announced its program last week and injected its first capital into three banks on Monday.

Shares of the newly nationalized banks - Royal Bank of Scotland, HBOS and Lloyds - slumped Monday, despite a surge in bank shares elsewhere, because shareholder value was diluted by the government.

The move, analysts said, makes the government Britain's biggest banker. And it creates a two-tier banking system in which the nationalized banks are run like utilities and others are free to pursue profit growth. As part of the plan, the chief executives of the three banks stepped down.

..deriding their sluggish decision-making and describing the political system as suffering from “institutional sclerosis [...] unable to make a decision to make this country healthy”.

His attack came hours after his bank had been forced to sell a stake in itself to the US Government, following the announcement of President Bush's plans to partially nationalise America's biggest financial institutions.

...

Mr Dimon, who has been tipped as a favoured candidate to be the new US Treasury Secretary in the event that Barack Obama, the Democratic presidential hopeful, wins next month's election, also attacked other Wall Street executives.

Speaking at the business school from which he graduated 20 years ago, he accused some of his rivals of failing to act quickly enough when it became obvious that America's banking system was experiencing intolerable strain.

Mr Dimon said: “I am shocked at the number of people who were just looking at the train coming down the tracks and were still worrying about whether they had a strategic plan for 2009. We cancelled all that. We cancelled all trips, all travel. We needed to have a sense of urgency and a lot of people did not have the ability to act.”

...

Mr Dimon also criticised Wall Street for devising such complex investments as collateralised debt obligations (CDOs). Speaking to more than a thousand bankers, he said: “CDOs squared? What the hell were we thinking? These things were way too complicated.”

Addressing the problem of banks with distressed assets, he said: “These problems do not age well. You have to have a lot of fortitude, to make the right decision and take the pain.”

Stock investors also need a lot of fortitude to deal with the wild gyrations of the market. I still believe that yesterday's rally will have legs.

My thesis remains that hedge funds, stock mutual funds, and pension funds will be buying dips on this rally to make up for losses suffered in the past two weeks.

I do not believe this is the ultimate bottom but a powerful bear market rally, one of many we will have over the next few years.

Between now about ~2014, will there be sustained moves higher? Absolutely! Will many months go by where the bulls are the winners? Yes. Obviously it's not a straight down line.

The artistry is going to be knowing, given current conditions, what the short-term horizon holds. There will be times (like last Friday) when I'm buying everything in sight. If I get my head screwed on right, there will even be times when I buy and hold for more than a day or two!

So let's see what tomorrow brings and remember, as bad as the stock markets seem these days, it could always be worse. Just look at what happened to Iceland's exchange today - it virtually melted away!

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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